‘We need to think about failure’ of banks, says APRA boss

The chairman of the prudential regulator says no level of capital can provide creditors with an absolute guarantee against the possibility of bank failure.

APRA chairman Wayne Byres delivered a speech titled ‘Banking on Capital’ at the Actuaries Institute Banking Conference in Sydney this week, where he emphasised that “a sole reliance on capital is an unwise strategy” when it comes to the resilience of Australian banks.

While he maintained that the steady accumulation of capital remains a “sensible course of action” for most banks, Mr Byres said that a stable and resilient banking system is not just delivered by more capital.

“Capital adequacy is a relative concept — is capital adequate relative to risk? When we judge a bank’s capital to be high or low, or something in the middle, we are making a judgement that takes into account a range of issues that impact on bank risk profiles: funding and liquidity, asset quality, governance, risk management and risk culture, to name a few, all come into the equation in some way or another,” he said.

“We also need to remember there are no guarantees. No level of capital (short of 100 per cent equity funding) can provide creditors with an absolute guarantee against the possibility of bank failure.

“To pick up today’s theme, we can’t always ‘bank on capital’: something can always go wrong. To attempt to provide the community with an ironclad guarantee that nothing can go awry would require severe limitation on the risk-taking ability of the banking system, and prevent it from fulfilling the vital and productive roles that it plays in intermediating between borrowers and lenders and facilitating the smooth functioning of payments throughout the economy. Put simply, a zero-failure regime is not desirable.”

Mr Byres said APRA and the Australian banking community must find a balance, and remember that ‘unquestionably strong’ will never equate to ‘invincible’.

“That in turn means we need to think about failure,” said the APRA boss. “And when I use the word ‘failure’, I’m not just talking about a classic case of insolvency or bankruptcy, but using it more broadly to capture situations in which the ongoing viability of one or more financial institutions is in serious jeopardy.”

The failure of a bank is not like the failure of a bakery, Mr Byres said, warning that the potential for contagion to other financial firms, not to mention the widespread adversity it can impose on the broader community, means the failure or near-failure of a bank is “no run of the mill matter”.

“So, if we start with the proposition that failures are inevitable, then I’d suggest the regulatory system needs to be assessed against two benchmarks: are failures nevertheless sufficiently rare, and do we have mechanisms to handle them adroitly when they occur? If the answer to both these questions is yes, then community confidence and trust in the financial system is likely to remain high.”

According to Mr Byres there are two basic types of failure: orderly and disorderly.

“To the extent we have failures, orderly failures are what we aspire to,” he said. “Orderly failures will typically have been anticipated, produce no loss to protected beneficiaries, and be managed in such a way that the firm’s critical functions are maintained without disruption while the situation is resolved. (Shareholders and other providers of capital of the non-viable firm may very well lose out along the way, but that is their lot in life).

To the extent any failure can be regarded as a success, then an orderly exit from the industry in this fashion is what we should strive for. For example, a firm that identifies it is approaching non-viability or a strategic dead-end, and seeks to merge with a stronger and more viable entity (sometimes with a nudge along the way from APRA) is a far from uncommon event in the Australian financial system. To the extent such exits can be classed as failures, or at least near failures, they are often so orderly that no one notices them.”

Disorderly failures, on the other hand, are to be avoided, warned Mr Byres. He described these as failures that “catch everyone by surprise, impose significant losses on those who the regulatory framework seeks to protect, and/or involve significant disruption to the smooth operation of the financial system, and economic activity more generally.”

“HIH Insurance would be the classic of this genre,” he said.

Mr Byres suggested the following preconditions that the public sector needs to put in place to avoid the disorderly failure of banks:

• “active supervision is at the heart of identifying the risk of failure early — it will be hard to anticipate problems if there is no one looking for them in the first place;• powers to intervene must exist — this is critical to being able to address small problems before they become big ones;• a willingness to intervene is also critical — powers are of no value if there is no capacity or willingness to use them when needed;• planning and preparation — ideally, contingency plans will have been prepared and tested in ‘peace time’ rather than thought up on the run in the midst of a crisis;• a capacity to maintain critical functions — an orderly resolution of a failure may take time, yet critical functions need to be maintained in the meantime; and• there will ideally be a safety net or backstop to provide additional confidence at a time of uncertainty — which will help avoid actions that are individually rational but collectively damaging."

"Adequate capital is undoubtedly critical to the stability of any banking system. But to return to today’s theme, we can’t solely ‘bank on capital’ to deliver safety and stability," said Mr Byres. "If we accept that failures, while hopefully still reasonably rare, are nevertheless inevitable, then preparation to minimise their impact is an essential investment. ‘Successful failures’ might seem a contradiction in terms, but they are far better than the alternative.”